Taking the Long View on Intel
By Monica Rivituso
INTEL (INTC) has seen better days, that's for sure.
The chipmaker's third-quarter report, which came after the close on Tuesday, was a big disappointment,
with earnings coming in two cents below consensus and gross margins declining. Given that analysts
were looking for Intel to wow the Street with an earnings surprise and a boost in profitability, investors took
the news especially hard. Intel's stock fell nearly 6% today, dragging the rest of the market down with it.
But that's old news. It's no secret that the average selling price (ASP) of the typical microprocessor is in
decline. And there's no arguing that declining prices in your bread-and-butter product eventually hurt
margins. Intel and its cadre of loyal analysts have tried their best to insist for about a year now that
increased volume for the company's higher-end chips would offset steep price declines on the low end.
But let's face it: When a $1,000 PC can do today what a $5,000 PC did a couple of years ago, demand at
the high end doesn't provide the opportunity it once did. If the slide in ASPs hadn't shown up this quarter,
it would have reared its ugly head before long.
What's becoming clear is that an investment in Intel is turning into a bet on a remarkable company's
ability to escape this rut. If you look beyond this quarter's report, and try to glimpse the future of the
technology business, you might see some things in Intel's behavior that are very encouraging indeed.
What's happening is that Intel is scrambling to build a business in networking chips -- the high-margin
silicon that may end up powering the Internet. And for a company that has grown fat from capitalizing on
the microprocessor business for almost two decades, that's a pretty big shift. While there will likely be a
day when Intel is a chipmaker of a different stripe, some analysts -- like SG Cowen's Drew Peck -- say
those growing pains could hurt the stock in the short term.
But Peck is hardly an Intel bear. On the contrary, "I think what they're doing is extremely smart," he says,
"but it's fraught with risk." The truth is, analyzing Intel will increasingly mean finding different metrics to
measure its progress. Microprocessor ASPs used to mean a lot. From now on, they'll probably tell the
same old story.
So what is Intel's new strategy? Clearly the company isn't going to bail out of microprocessors. While
margins may shrink in this business, Intel still has what amounts to a monopoly market share (talk about
a cash cow). Rather, Intel has tried to determine what the most profitable area of the chip world will be in
the coming decade so it can improve the mix of its portfolio. It didn't have to look far: The answer was
networking, the plumbing of the Internet.
While PCs have become so powerful that a relatively inexpensive desktop can now serve up a Web site,
the bandwidth connecting those computers hasn't caught up. Intel figures it can use its vast engineering
talent to devise "networking" chips that provide intelligence to speed up those connections. That way,
while other companies build the Internet's connective tissue, Intel could manufacture the nervous system.
The company's hope is that equipment outfits like Cisco Systems (CSCO) would then build boxes around
Intel silicon. (See "Intel's Networking Power Play" for a more detailed discussion of the company's
strategy and its obstacles.)
This quarter alone, the chipmaker spent $3 billion on four acquisitions designed to strengthen its position
in the networking arena: Level One Communications, Dialogic, Softcom Microsystems and Netboost.
"From the top to the bottom of the communications business, they're making investments," Peck says.
The move into the networking arena, of course, is a controversial one. Not only is it brand new territory for
Intel, but the company's vision of a networking chip conflicts with Cisco's vision, among others.
Essentially, Intel is trying to rewrite the rules (again, see "Intel's Networking Power Play"). But Danny
Lam, an industry analyst and director of Fisher-Holstein, points out that the chipmaker has successfully
shifted gears once before. In the mid '80s it decided to get out of the memory chip business. "Clearly the
company has demonstrated the capacity to change its stripes once before," he says.
Getting out of a business is much easier than getting into one, however, which is why Peck is short-term
skeptical. And he sees some of the growing pains showing up already. In Intel's quarterly report, Peck
says there are clear signs the acquisitions led to a sharp rise in operating expenses. The purchases
mean Intel is now paying more people and racking up more R&D costs. That will likely prove a drag on
earnings through next year, Peck says. And seeing as how the benefits from the technologies Intel
acquired might not be seen for another 18 to 24 months, "there's going to be a long gestation period while
they reinvent themselves," Peck explains.
Peck found it disquieting that Intel didn't discuss any of its long-term goals on yesterday's conference
call. Management acted as if the quarter wasn't representative of a larger transition. But that's typical
Intel. Even as he cut his rating on the stock to Neutral from Buy, Peck emphasized that he's not negative
on the chip giant. It's only the short term that bugs him. Would he recommend the stock at some point in
the future? Probably.
But by then, he says, Intel might be covered by a networking analyst.
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